The equities market is in such a hyper bullish mode, it is no longer a surprise to see the Nasdaq, S&P 500, Dow, New York Stock Exchange, and Russell 2000 all hitting all-time closing highs simultaneously. Amazon, Apple, and Goldman Sachs also all hit new all-time highs. Even with this broad-based rally, the VIX was up as it remains at an 11 handle.

The chart below reflects how easy it would be for the market to absorb hedge fund selling. The Novus liquidity index (blue line) measures the amount of hedge fund selling the market can absorb. Currently the market can only absorb 13% of the industry’s $2 trillion in equities. This means liquidity is at an all-time low, going back to 1999. The white line shows how hedge funds are crowding into the same trades. This is a death cross in my mind because hedge funds are all in the same stocks and liquidity is low. Along with the stocks I mentioned, hedge funds are also buying into industrials as the Trump-led reflation trade is still going.

The market isn’t in a good position to handle an event which causes volatility. The question is what event could cause volatility to spike. The first possibility is a mistake in fiscal policy which is why I will be watching the President’s speech on Tuesday very closely. The second is the French presidential election. If Marine Le Pen wins, she will call for a referendum to leave the EU. While the U.K. was in the EU, it never used the euro currency and had its own independent central bank. Therefore, Brexit never had a chance of ending the EU. The worry was it could be the sparkplug for other countries to leave the EU. If France leaves the EU, there’s a good chance the entire thing unwinds and a new organization is created. The reality is Brexit was signal more than a spark because the anti-EU sentiment is being caused by the same issues throughout the EU. Europeans who want to leave the EU are frustrated with the open-door immigration policy and the stagnant economy.

The campaign is reaching the pressure level seen in the American presidential campaign in September. Each statement made by the candidates is looked at with a magnifying glass. Any misstep can hurt a candidate enough in the polls to change the outcome of the race because it is very close. The latest controversy in the election is Marine Le Pen’s refusal to wear a headscarf when meeting with Lebanon’s top Sunni Muslim cleric. Macron had a verbal blunder when he said colonialism is a crime against humanity in his visit to Algeria. Fillon has rebounded after falling in the polls due to accusations that he misdirected public money to hire family members. There will always be mini-controversies. The goal for each candidate is to connect with the voters without putting their foot in their mouth.

The biggest update I have from my last article on the election is that the left’s goal to unite to have a candidate which is more competitive with Le Pen, Macron, and Fillon isn’t going well. Hamon, who has 16% in the latest poll, and Melenchon, who has 12% in the poll, traded verbal jabs at each other. It’s not an easy situation because neither candidate wants to drop out, but both know neither will be able to make it to the second round of the election. It’s a game of chicken to see who will drop out. Politicians love to further their own careers. They only make tough decisions after it’s clear they have no support. One example of this was John Kasich staying in the American presidential race even after he had no chance to win.

It may be good for the odds that they combine candidacies if both slump in the polls. The secretary general of the Socialist party said the left has no hope to make it to the second round unless they combine forces. I don’t think these minor jabs mean the chances of an agreement are impossible. However, one thing to keep in mind is politics is messy. Sometimes if voters feel candidates are trying to game the system, they back away from supporting them. We saw this with the agreement between Ted Cruz and Kasich to campaign in certain states. The plan to manipulate the vote, hurt support for both candidates. The 12% and 16% that Melenchon and Hamon have respectively won’t necessarily add up to a a single candidate receiving 28%, once one of them drops out.

As I mentioned, Le Pen has a great shot at beating a left candidate in the second round of voting. She is losing versus the two center candidates in head to head matchups. The key factor which will determine who wins the election is how much momentum Le Pen will gain after winning the first round. She is in the lead in every poll (except one she’s down by 0.4%) in the past month. There’s two weeks between the first and second round which will the most important time in the race. The chart below shows the odds of each candidate winning the race. This explains why the risk premium in the French 10 year bond over the German 10 year bond is at 79.3 basis points, a 4 year high.

The chart below shows the latest polls in a head to head matchup between Fillon and Le Pen. Le Pen took a small dive of 2 points in the latest poll as she is now losing by 14 points. Her boost from winning the first round is tough to quantify, but it does mean it will be closer than these polls indicate.

Conclusion

The oddschecker has Le Pen at a 34% chance of winning. As we saw with the Trump election and Brexit, these betting odds aren’t always accurate. The French election is only effecting French bonds now, but it will cause American equities to sell off in March, April, and May if it looks like the election is tightening. On the bright side, Le Pen will likely moderate her tone to gain a bigger base of support, so the market may be less spooked by the prospect of her winning.